Tuesday, May 17, 2011

Hedge Fund Return Timing Bias

It's well-known that there's a backfill and survivorship bias to many Hedge Fund indices. As most indices promote their product, this is understandible. Yet just as with the equity risk premium, the hedge fund bias usually neglects the adverse timing bias: that market inflows and outflows make the raw time series returns overestimate the return to an average investor. Thus, many funds with $100MM in assets have great return their first year, of say 50%, and then get on the cover of a big magazine, get $1B, and lose %20. Is the return on such a fund the average--geometric or arithmetic--of the 50% and -20% return, or should it weight the 20% loss more, reflecting the performance of the average investor in that fund?

I remember in 2004 or so when convertible bonds got rocked, convertible bond indices simply disappeared, merged into other indices within broader Fixed Income categories. But then, after a strong rebound, they returned as if nothing happened.

Ilia Dichev has a new paper out (with Gwen Yu) in the JFE documenting this bias is around 3-7% for hedge funds, just as he found this bias was around 3% for equity indices:

We use dollar-weighted returns (a form of IRR) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our main finding is that annualized dollar-weighted returns are on the magnitude of 3 to 7 percent lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the S&P 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.

Antti Ilmanen estimates a 3-5% survivorship bias, and a 1-3% backfill bias in Hedge Fund indices, so be sure to add to those. Here's something simple and valuable the new Consumer Financial Protection Bureau can do: monitor and disseminate accurate asset class performance data, eliminating the bias present in most indices that tend to inflate all of them.

6 comments:

Yeah the Consumer Financial Protection Bureau is a ridiculous idea and a complete waste of time, but if there's one thing they could do it would be to protect sophisticated hedge fund investors from predatory index-makers.

We had tens of agencies with the same goal of protecting consumers who all failed miserably in the past crisis, so I find your faith in the CFPA naive--the explicit objective by regulators was not lacking. Having accurate information is something an independent group, representative of society, is a classic public good, something that solves a problem with less distorting incentive problems than simply letting the marketplace generate this information. If you don't like this function I propose because it would be applied to asset classes that predominate with rich people, you must recognize that most asset classes are dominated by rich people, and I guess you then simply want to engage in redistribution via financial regulation. That's a tortured means to an end, much less efficient than simply giving poor people money directly.

As we saw with mortgage backed securities, it would have been nice to know that interest only, no-down payment loans, were increasing dramatically as a percent of these securities, but such information was difficult to get pre-2007. It seems like a simple, good thing to do.

Not sure where I expressed my faith or lack of faith in the CFPA. I just thought it was funny that you seem to be saying that if there's one thing the government can do for the public, it's helping hedge fund investors get better information. Presumably the market works perfectly well for anything involving consumers who are less wealthy and less educated.

I think what he's saying is that everything else that's been proposed for the CFPA to do is a waste of time, so this relatively obscure but actually valuable function rises to a level unexpected by a casual observer, such as yourself. :-)